US Dollar In Other Possible World

While I asserted that the US dollar is not losing its value, I am much less certain about whether the US will lose its value. Markets do not operate based on what is happening now, but on what is expected to happen. So it appears that the gold market is expecting hyperinflation of some sort or the crash of the US dollar because of the monetary expansion and deficits spending (Do read the excellent anatomy of hyperinflation by Cullen Roche). Though I would like to consider an alternative scenario.

The US economy is in a balance sheet recession, which required long and painful deleveraging. The process of deleveraging would be deflationary: households and businesses would save more and borrow less, and businesses will not invest if they do not see enough demand in the market. The only thing that is not really deleveraging is the government, which IMF says it has no credible plan on debt reduction. So despite all the money being poured into the system after two round of quantitative easing, they have not really reflate the economy even commodities prices increased. The trend of core inflation is still frightfully similar to what has happened in Japan after 1990s.

Source: St. Louis Fed, Japan's Statistics Bureau

Consider the fact that quantitative easing does not work, which means injecting money into the system does not reflate the economy which is undergoing a deleveraging process, which is deflationary. Deflation means that the purchasing power of money increases. The value of money increases in a deflationary environment despite the expansion of monetary base. The example here is Japan, where quantitative easing was first used in 2001. Despite all those volatility, the trend is clear: JPY appreciated just as I have pointed out long time ago, and Japanese Yen is not hugely overvalued despite its strength on a absolutely purchasing power parity basis. So here is a case where the government was running a huge deficit and the central bank is expanding monetary base, yet the currency increase in value. I am not saying that this must happen to the United States, but this is the scenario that is not even considered.

Source: St. Louis Fed

There is only one problem. While both Japan and the United States are awful as far as public finances are concerned, the holders of Japanese government bonds are largely Japanese, whereas the holders of US Treasuries (exclude the Federal Reserve) are largely foreigners.